Bitcoin as an Inflation Hedge: Pros, Cons, & Comparison

Rising costs of both goods and services are squeezing budgets and eroding savings, making it essential to protect one’s wealth. As such, many are asking whether or not bitcoin is an inflation hedge.

Understanding Price Inflation

Price inflation is defined as the increase in the prices of goods and services over time. This means that the purchasing power of money decreases as more currency is required to buy the same items. Two primary ways that people talk about inflation are the Consumer Price Index (CPI) and the relationship between goods inflation and asset inflation.

• Consumer Price Index (CPI) Inflation: CPI measures the average change over time in the prices paid by consumers for a market basket of consumer goods and services.
• Goods Inflation vs. Asset Inflation: Goods inflation affects everyday items like food and clothing, while asset inflation impacts investments like real estate and stocks.

The Cause of Inflation

Money Supply and Monetary Policy

The cause of monetary inflation is the increase in money supply. Printing money, often referred to as fiat currency debasement, reduces the value of each currency unit.

Economist Milton Friedman once said that inflation is created by “too much government spending and too much government creation of money and nothing else.”

Quantitative Easing and Open Market Operations

One way that the government creates money is through Quantitative Easing (“QE”). QE is when central banks buy financial assets with money that previously did not exist to boost the money supply, encourage lending, and spur investment.

It is a strategy that has been used with increasing frequency. In times of low inflation, the Federal Reserve uses a similar strategy called Open Market Operations (“OMO”), which usually includes the purchase (or sale) of U.S. Treasury bills to influence short-term interest rates.

Other Inflationary Policies

In addition to QE and OMO, there are other policies or actions that can affect the money supply. One of these is the lowering of interest rates. When interest rates are lowered, this encourages lending because the cost for borrowing money becomes cheaper.

Fractional Reserve Banking (FRB) exacerbates this issue by allowing banks to hold just 10% of deposits in reserve, lending out the rest. This process expands the money supply, as loans get redeposited and multiplied across the system. 

For example, when an individual takes out a $50,000 car loan from a bank, the bank creates a deposit in the borrower's name. This money didn't previously exist, so the loan effectively increases the money supply.

FRB increases risk—if too many people withdraw their money at once, banks might run out of money and face insolvency. To make matters worse, the Federal Reserve announced a zero percent reserve requirement in 2020.

The government has many tools at its fingertips. While some economists would make the case that there are many non-governmental reasons for inflation, the reason for inflation always points back to the creation of more money.

Issues like supply chain disruptions, supply-demand imbalance, and resource constraints tend to be downstream effects that have their root in monetary considerations.

Why Hedge Against Inflation?

Hedging against inflation is crucial for several reasons:

• Preservation of Purchasing Power: As inflation erodes the real value of money over time, maintaining purchasing power is vital.
• Investment Protection: Safeguarding investments from losing real value ensures financial stability.
• Financial Planning Stability: Ensuring that savings retain value is crucial for future needs like retirement and education.

Bitcoin as an Inflation Hedge

Properties of Bitcoin

Bitcoin has several unique properties that make it a potential hedge against inflation:

• Fixed Supply: With a maximum limit of 21 million coins, bitcoin's scarcity can prevent debasement.
• Decentralization: Unlike traditional currencies controlled by central authorities, Bitcoin operates on a decentralized network, so the rules cannot be manipulated or changed.
• Security: Robust cryptographic measures protect bitcoin transactions from being reversed or falsified.
• Transparency: The blockchain ledger is publicly verifiable, minimizing the need to trust a centralized entity with asymmetric information.

Comparison with Traditional Hedges

Gold

Gold has historically been considered an inflation hedge due to its scarcity and durability. However, compared to bitcoin, gold lacks portability and requires significant resources to maintain its security.

Real Estate

Real estate is another traditional hedge, offering tangibility but posing liquidity challenges, high transaction costs, and significant maintenance fees (including taxes).

Stocks/Bonds

While stocks and bonds do offer returns, their performance often correlates with economic cycles, making them more volatile during inflationary periods.

Risks and Arguments Against Bitcoin

Volatility

Bitcoin's price volatility is a significant concern for some. Unlike traditional assets, its value can fluctuate dramatically over short periods.

Regulatory Risks

The potential for increased government regulation or outright bans could impact bitcoin's effectiveness as an inflation hedge. This greatly depends on the jurisdiction in question.

Technological and Security Risks

Hacking incidents on exchanges or the loss of private keys pose risks to bitcoin holders. For those not willing to take the proper precautions by safely taking self-custody of their bitcoin, this could pose a risk.

How Bitcoin Fixes Inflation

Bitcoin cannot fix inflation for everyone overnight, but it may do so over the long run. Jeff Booth makes the case that Bitcoin could lead to a world where things continually fall in price compared to bitcoin.

He argues that price deflation is already a reality for long-term bitcoin holders. While inflation cannot be fixed immediately for everyone, it can be countered today for those who own bitcoin. Here are three key ways bitcoin does this:

1. Preserving Value Through Scarcity

Bitcoin's fixed supply of 21 million coins ensures it remains scarce. Unlike fiat currencies that can be printed at will, bitcoin cannot be debased, making it a compelling candidate as an inflation-resistant asset.

2. Borderless Commerce and Accessibility

Bitcoin enables global transactions independent of unstable local currencies, providing a stable store of value in volatile economies.

3. Transparency and Decentralization

Operating on a transparent blockchain reduces reliance on potentially flawed monetary policies from central authorities. This decentralization makes bitcoin resistant to centralized manipulation.

Conclusion

Bitcoin's unique properties—decentralization, fixed supply, security, and transparency—position it as a potential hedge against rising inflation.

Comparing it with traditional methods suggests that, while it has risks like volatility and regulatory uncertainties, its benefits merit consideration.

As inflation concerns grow, exploring how Bitcoin hedges against inflation could help protect your long-term wealth in an increasingly uncertain economic landscape.

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